Monday, October 5, 2009

Constitutional Financial Innovation

I had a number of interesting conversations over the weekend about housing derivatives. People have reminded me that are plenty of derivatives that trade without being able to purchase the underlying, an obvious one being weather derivatives. Provided there is enough liquidity, people can hedge (or synthetically hedge) within the futures market itself. But the issue then changes to whether or not we can get enough liquidity – and I don’t see enough people wanting to get on the other side of the housing market at any time to get liquidity going.

And I had no idea Shiller has revived his Microshares see-saw idea to try and sell these derivatives. It’s based on the same terrible leveraged ETF design as his crude oil ETF, the one that imploded last year in a display the Wall Street Journal called “This fizzle, after a year-and-a-half run, is one of the highest-profile embarrassments for the growing ETF industry over the past year. Turns out the funds, the brainchild of famed Yale economist Robert Shiller, were too smart for their own good.” (The WSJ piece is a good overview.) Good luck with this the second time around; nice 1.25% expense ratio on the fund (can you call it a fund if you hold leveraged T-bills instead of the underlying?).

Constitutional Financial Innovation

I’m going to read one level into Shiller’s argument and note that, at the end of the day, he’s concerned that average Americans need better tools to manage the risks of their incomes and investments. I think Reihan Salam and other smart neoliberals has flirted with this idea of derivatives designed for the middle-class to help them deal with risk management in a post-Risk-Shift world. The idea that consumers could buy put options on themselves – options that are more valuable the worse things get, that can provide a floor under which losses could not go – to help them manage the downside risks they face in volatile assets and increasingly uncertain labor markets, would be a huge innovation if we could pull it off. But in the same way that nobody would naturally want to insure the housing market, I can’t see enough people wanting to insure the middle class to get instruments like this to start.

Here’s something that should make conservatives happy. The best, and I mean the best, put option contract for consumers ever conceived, is written right into The Constitution: “To establish…uniform Laws on the subject of Bankruptcies throughout the United States.” Yes, viewing bankruptcy as a financial engineer does, as a put option on assets and volatility for consumers, handles all of this risk management in a way that is cleaner and more efficient than any derivatives market foreseeable in the future.

Bankruptcy As a Put Option

Shiller is worried that we don’t have a way for a household to write a put options on its assets. For a simple example, let’s say a household has a house worth $500k (assets), and a debt worth $400k (liabilities), and there’s a very high probability that it can make the payments on those liabilities.

People like Shiller wants you to be able to pay a small fee so that if the asset is suddenly worth $300K you get $100K in value – the put option is presumably written at the level of liabilities. He also wants you to be able to hedge income, so that if the probability of you being able to make the payments decreases – long unemployment spells, health problems, etc. – you can get a payout that would reduce the liability to the point where the house can manage them.

Notice that if the household goes bankrupt, because assets are less than liabilities, liabilities are marked down accordingly, directly as if a put option has been exercised. In an ideal bankruptcy, it would be marked down that $100K in the example above, or marked down to the point were payments have decreased so they are manageable.

Taboo Talk

I know it is taboo to talk about it this way, since bankruptcies are nasty zero-sum games evil people do but put options are wonderful gee-whiz innovations that are in no way zero-sum, but I honestly don’t see a net difference between a household declaring bankruptcy and a household collecting money on a put options it has written on itself. You are being charged for credit risk by the people who lend to you; you are already paying the fee for having this put option.

If anything, bankruptcy handles the moral hazard problem better with these “insurance” like contracts and it is held by the debt lender, so the cost of the option (how much extra you are charged to compensate for credit risk) can be individualized in a way a commodity market couldn’t handle. Sure lawyers collect a fee for pushing people into bankruptcies, but I have a hard time believing it’s any worse than a 1.25% expense ratio the derivative sellers are getting. And key is that it is only exercised if the household can’t manage the liability payments – someone has to pay me, zero-sum, if my house declines in value even if I can make the original payments on liabilities with this hypothetical put option. Someone only has to ‘pay me’ in bankruptcy if I can’t manage the payments – in this case, I hold this risk longer as long as it is optimal for me to do so.

I need to flesh this out more, and I’m interested in the minute differences between the two in equilibrium. But the last time I checked, we are currently trying to dismantle this financial innovation as it is part of the neoliberal vision of governance to dismantle and then privatize the social safety net, regardless of whether or not a functioning market is in place and how well the social safety net provided. If anything we should be expanding this – mortgage cramdowns would have been the financial innovation needed to survive the foreclosures and raw neighborhood destruction that is going to characterize 2010.